Borrowing Constraint as an Optimal Contract

40 Pages Posted: 3 Jun 2010 Last revised: 6 Jun 2010

See all articles by Borys Grochulski

Borys Grochulski

Federal Reserve Banks - Federal Reserve Bank of Richmond

Yuzhe Zhang

Texas A&M University

Date Written: October 20, 2009

Abstract

We study a continuous-time version of the optimal risk-sharing problem with one-sided commitment. In the optimal contract, the agent's consumption is non-decreasing and depends only on the maximal level of the agent's income realized to date. In the complete-markets implementation of the optimal contract, the Alvarez-Jermann solvency constraints take the form of a simple borrowing constraint familiar from the Bewley-Aiyagari incomplete-markets models. Unlike in the incomplete-markets models, however, the asset buffer stock held by the agent is negatively correlated with income.

Suggested Citation

Grochulski, Borys and Zhang, Yuzhe, Borrowing Constraint as an Optimal Contract (October 20, 2009). Available at SSRN: https://ssrn.com/abstract=1620042 or http://dx.doi.org/10.2139/ssrn.1620042

Borys Grochulski

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

HOME PAGE: http://www.richmondfed.org/research/economists/bios/grochulski_bio.cfm

Yuzhe Zhang (Contact Author)

Texas A&M University ( email )

Langford Building A
798 Ross St.
College Station, TX 77843-3137
United States

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